Asia's Fight to Stem Fund Outflows Just Starting

A surprise interest rate hike from Indonesia came amid one of the worst weeks for emerging markets as heavy capital outflows pounded their equities and currencies. Now analysts anticipate governments to take further action to stem the tide.

On Thursday investors were taken aback by a 25 basis point interest rate increase from Indonesia, the first hike by an Asian central bank since 2011, following several rate cuts in recent times.

"We will probably see stronger policy moves. I think the central bank of Indonesia will seriously consider a 50 basis point hike for the main policy rate," said Vishnu Varathan, market economist at Mizuho Corporate Bank in Singapore. "Some degree of capital controls cannot be ruled out at this point," he added.

The U.S. Federal Reserve's $85 billion per month bond buying program has fed a steady stream of cash into emerging markets in recent years. But speculation over the potential tapering of the program, which has intensified in recent months, has led to a spike in risk aversion and heavy outflows from emerging markets in recent times.

Stock markets in Thailand, the Philippines and Indonesia have erased considerable gains made this year, while the Nikkei has fallen 20 percent in the past few weeks alone.

Central banks from India, Brazil, Indonesia and Turkey all intervened in the currency markets this week to shore up their battered currencies, which fell victim to exiting foreign funds. For example, the Indian rupee hit a record low of 58.98 against the U.S. dollar on Tuesday before the Reserve Bank of India intervened.

Robert Prior-Wandesforde, director of Asian Economics Research at Credit Suisse, said while he doubted Asian central banks would follow Indonesia's example and raise rates, he did anticipate other policy options in a bid to control capital outflows.

The central banks in the Philippines and South Korea which also met on Thursday kept rates steady.

"More likely than widespread interest rate tightening is verbal intervention in currency markets, backed up by currency intervention - this is already happening in most Asian currencies as central banks attempt to 'smooth volatility'," he said.

Wandesforde said he did not expect emerging market governments to go down the path of capital controls as yet.

"We are some way away from new capital controls to limit outflows," said Wandesforde. "For the hotter ASEAN [Association of Southeast Asian Nations] markets, the withdrawal of liquidity should really be considered good news...assuming, of course, it doesn't go too far. In our view, monetary conditions had been too loose for too long, leading to overheating pressures - some of which could now be eased."

Richard Jerram, chief economist at the Bank of Singapore, said the likelihood of policy measures to control outflows would be dependent on whether the country was happy with downward pressure on its currency or not.

Countries with hotter currencies like Thailand and the Philippines would probably be glad to have some downward pressure, he said, while the likes of South Africa, Brazil, Indonesia and India would be less happy with the declines due to their already hefty current account deficits.

"I would not expect capital controls to be the next step, but it is possible that we might see more interest rate hikes and further currency intervention," said Jerram, adding that he expected Brazil to be the next country to raise rates.

The Brazilian central bank hiked its benchmark interest rate by 0.5 percent in the last meeting at the end of May. It's set to meet again on July 9 and 10.